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Avoid Litigation; Protect Your Business and Estate Plan with a Buy-Sell Agreement

This article by Stuart Adams appeared in The Advisor, Fall, 1997

A buy-sell agreement is a device commonly used to keep the equity of a closely held company with multiple owners from being transferred, voluntarily or involuntarily, out of the hands of the signatories, without prior agreement. This form of this agreement is, perhaps, most commonly recognized as the stock restriction agreement used with corporations, and that is the form, for the sake of simplicity, in which it will be most commonly referenced here. It may also be used, however, as part of a partnership agreement or in the operating agreement of a limited liability company.

In the case of death, disability, departure from work in the company, divorce, remarriage, bankruptcy or other "trigger" event, this agreement would determine whether a sale or transfer of the stock or other equity interest of one of the owners could occur and at what price. This can be useful to keep a stranger or other unanticipated shareholder, such as another shareholder’s spouse (divorce), executor or heirs (death), creditors (bankruptcy or judgment), etc., from becoming your "partner."

I do find that when some clients start to consider the options in a buy-sell agreement, they simply "glaze over" like they do when I recommend they update their business plan. With both documents, a little work and thought can pay big dividends later.

An agreement restricting sale of an interest in a business can also be useful to prevent litigation, expensive valuations or impossibility of purchase, by the surviving shareholder. The device can be very flexible. You can determine when a shareholder can or cannot transfer stock and at what price. You can also provide for insurance to fund the buy out of another shareholder in the case of death. The device can certainly save a corporation from disaster and prevent disputes in future, since everyone involved should know where they stand. In my opinion, this is one of the best and cheapest ways to prevent disputes between shareholders, as well as disputes between surviving shareholders and the spouse, heir or creditor of another shareholder after one of the "trigger" events has occurred.

This device is best put in place when a company is first created and it should then be periodically reviewed to determine if changes are warranted, just as with the estate plan of the owners. Once stock is issued, the device can still be put in place if all stockholders execute the agreement. Some but not all the stockholders could enter into such agreement, but it does not bind those who do not sign it nor those who receive their stock without knowledge.

There are three basic types of buy-sell agreement, the use of which depends upon tax, insurance and practical factors: cross purchase, redemption, and cross purchase redemption mixture. In a cross purchase agreement the stockholders either obligate themselves or have the option to purchase the stock upon a triggering event. Redemption agreements are where the corporation obligates itself to or has the option to repurchase the stock upon a triggering event. Under the mixture concept, the corporation has the first right or obligation to purchase and then, to the extent to which it fails to exercise its option, the stockholders may or must do so.

There are many choices, having both tax and non-tax implications, that must be made in adopting a buy-sell agreement. The major choices include:

1) the identity of the purchaser;

2) the pricing mechanism;

3) the triggering events;

4) the degree to which the arrangement is optional or mandatory; and

5) interim restrictions on transfer.

Because the purchase price usually represents a large sum for the business, funds for payment are rarely available from general working capital, but are likely to require a special funding source. One common source is life insurance.

Life insurance can be used to fund either a redemption or a cross-purchase agreement triggered by death. In either case, the premiums, which usually are nondeductible, must themselves be funded. In a redemption agreement, premium payment by a corporation raises dividend issues for the shareholders or accumulated earnings tax issues for the corporation.

Determining the price or a pricing mechanism normally proves to be the most difficult task in establishing a buy-sell arrangement. Prices are usually established contemporaneously in the market by express or implicit bargaining between a willing buyer and a willing seller, neither under any compulsion to buy or sell. Although the initial arrangements at the time the agreement is entered into usually reflect arm's length bargaining, it is obviously impossible to predict accurately the future condition of the business when the purchase under the buy-sell agreement will be made. Thus, to provide for a future purchase, there must be a current mechanism to fix a future price. Basic pricing mechanisms that may be used in a buy-sell agreement include:

1) fixing price per share in the agreement, often with a provision of subsequent adjustment;

2) providing a formula, usually starting with book value or earnings;

3) using an outside appraiser or, under a right of first refusal, the price set by a third party buyer;

4) using a kind of auction in which one shareholder fixes a price per share and the other decides whether to buy or sell at that price; or

5) using a hybrid.

Providing a fixed price in the buy-sell agreement is undoubtedly the simplest method of determining the price. Unfortunately, except in unusual situations, changing circumstances will make the fixed price inappropriate in the long run and may do so fairly quickly. Accordingly, fixed price agreements frequently provide for the agreed price to be modified by subsequent agreement and may set a fixed period after the end of the corporation's fiscal year for the redetermination.

Use of a formula is a better, and more common mechanism that more closely approaches use of the market price available for public corporations. The most common formulas are based on reported earnings, on book value, or on a combination of the two. Although using a formula appears quite mechanical, devising a formula requires several difficult determinations. The first is whether the formula is to be based primarily on book value or earnings.

To the extent that the purpose of a pricing mechanism is to approximate the price that would be paid in a market transaction, no fixed or formula price can satisfy the goal. A buy-sell arrangement that does not prohibit transfers, but limits them by a right of first refusal, relies on the market. Where keeping shares in the hands of active shareholders is a major goal and sales to outsiders are prohibited, the closest approach to the market is outside appraisal.

Another mechanism that approximates the market mechanism allows one shareholder to price and one to choose. As applied to a buy-sell arrangement, this involves one shareholder fixing a price per share and the other shareholder deciding whether to buy or sell at the stated price. While this method works quite well as a dispute resolution mechanism in corporate joint ventures or otherwise, it is of questionable utility when death, disability, or retirement involves a shareholder.

A combination agreement seeks to use the advantages of one of the pricing mechanisms to offset the disadvantages of another. The cost is that a combination agreement is more complex than any individual type of agreement.

The death of a shareholder is probably the most common triggering event because death inevitably involves change of the owner of the shares, usually

accompanied by bringing in new owners with no prior active involvement in the business and probably without close personal relations with those who will be carrying on the business. When the buy-sell arrangement is triggered by death, the shares have a basis equal to the estate tax value. This almost inevitably means that there is little or no taxable gain on the sale as long as the sale is treated as a sale or exchange. Any excess or deficit of the selling price of the shares over the deceased shareholder's basis immediately before death is not income in respect of a decedent.

The purchase price under a buy-sell agreement can be paid over a period of time after the triggering event has occurred. Deferring payments reduces the financial burden on the corporation or remaining shareholder. It also delays recognition of gain or income by the withdrawing shareholder until payment is received.

The buy-sell agreement constitutes a great insurance policy to help perpetuate the desires of the founders for continuity of transition of ownership in their company. Additionally, as pointed out in an earlier article in this series, it can be a useful estate planning technique. Look into its uses in your business, and be sure to review the tax consequences with your tax advisor.

Stuart  Adams Law Office, P.S.C.
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Prospect, Kentucky 40059-7673
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